While standard microeconomic theory suggests that firms have no power over setting wages when markets are perfectly competitive, this view obviously clashes with the perceptions of the casual observer. This column uses data from Sweden to investigate the extent to which differences in firms’ pay are related to differences in physical productivity. It finds that firms that benefit from positive productivity shocks increase the wages of incumbent workers, and in particular firms among which there is substantial labour mobility. The evolution of productivity among such firms appears to be a crucial determinant of workers’ wages.

Does the productivity of your firm affect your pay? Standard microeconomic theory says no. Firms have no power over setting wages when markets are perfectly competitive. All they can do is hire as many workers as they need for each type of labour at their respective market wages. This view obviously clashes with the perceptions of the casual observer. Some firms pay higher wages than others. In some cases, wage differences seem to exist to compensate for unpleasant conditions. Firms operating in risky environments, where workers need to stand for long hours, for example, might have to pay higher wages to attract applicants. Other firms simply seem to be better for workers, paying higher wages and even offering other attractive amenities in the bundle.

Of course, many strands of modern economic theory predict wage differences across firms for identical workers. The work of recent Nobel laureates Peter Diamond, Dale Mortensen and Christopher Pissarides provides one such explanation. Their point of departure is that searching for a job is a costly activity. Workers have to ask friends and family about possible vacancies, look for vacancies online, send out CVs, and participate in many rounds of interviews. The process is also costly for firms. They need to post their vacancies, process them, interview candidates, meet to rank them, and make selections. This takes time and costs money. The costs imply that when a candidate reaches the final stage, the two sides have to decide whether or not to keep on looking for alternatives or strike a deal. Workers have a minimum wage they are willing to accept in mind, which is called their reservation wage. Below that, they are better off rejecting the job and continuing their search. The value of the match from the point of view of firms depends on profit expectations. These, in turn, depend on productivity developments, on how appealing to the public their goods and services will be, and other costs including those of labour. Depending on their relative bargaining power, the worker and the firm will negotiate wages and other conditions of the job. Economists refer to these search and matching costs as frictions.

What does the empirical evidence tell us? Two stylised facts have been corroborated by empirical studies in a multitude of countries and economic conditions. The first is that larger firms pay higher wages (Oi and Idson 1999). The second is that more profitable firms share some of these profits with their workers in the form of higher wages (see Card et al. 2014 and references therein). The two set of facts are obviously interconnected, as it is often the case that larger firms make higher profits. The empirical evidence is very robust and shows that larger and more profitable firms pay higher wages, not only because they attract more skilled workers. Identical workers are paid better if they work for these firms. A question that has proven much more difficult to answer is what’s behind these facts. Is it that larger firms or more profitable firms pay higher wages because they are more productive? Or is it instead that they have an advantage because consumers have a preference for their products, and the extra profits generated by this demand are shared with workers?

Why has an answer to this question proven so elusive? An important factor in this is the problem of measurement. Economists use the concept of total factor productivity (TFP) to measure how productive a firm, an industry or a country is. TFP cannot be observed directly. It is instead calculated as the residual of total output that cannot be explained by inputs – labour, capital, and, depending on the measure of output, intermediate goods. Determining TFP at the country or industry level is relatively simple (although of course there is a lot of debate on how to do so correctly), but at the firm level becomes very complicated. This is because we typically observe firms’ sales (i.e. the number of units sold of each product produced by a firm multiplied by their prices), but in order to build a measure of TFP we need a measure of physical output, i.e. we need to separate prices from volumes sold.

In a recent paper (Carlsson et al. 2016), we provide an answer to the first question: How important is firms’ productivity for worker wages? We use one of very few data sets that contain measures of prices and sales for Swedish manufacturing plants, allowing for the construction of a measure of TFP that departs from volumes sold. Linking this information with the wages of all workers employed in each firm, we provide compelling evidence of the importance of firms’ TFP for worker wages. Usual econometric concerns such as differences in fixed firm-level wage policies, assortative matching, and endogenous match quality are dealt with by focusing on time-varying productivity for ongoing matched worker-firm pairs.

But while firms’ productivity matters for wages, they matter less than one might have initially thought. From one year to the next, a typical change in firm level productivity explains some 25% of the observed change in workers’ wages. If you allow for a longer time span, the response increases, and TFP changes or ‘shocks’ can explain up to 50% of the observed wage changes. These results suggest that there is a lot of space for other shocks to affect wages. New consumer tastes and other demand shocks for each firm’s products are primary candidates. Recent evidence suggests that firms’ demand shocks matters more than firms’ TFP shocks for other firm-level outcomes, including firms’ closure (Foster et al. 2008), firms’ growth (Foster et al. 2016, Pozzi and Schivardi forthcoming) and hiring and firing policies (Carlsson et al. 2014).

Our paper offers a second interesting insight. It turns out that workers’ wages are about three times more responsive to TFP shocks that are shared with other firms in the same industry than to shocks that hit a single firm in isolation. We evaluate two competing hypotheses to provide an explanation. The first is the wage bargaining structure in Sweden, which takes place predominantly at the industry level. Unions may better help workers coordinate their efforts to extract a bigger share of the pie when the productivity improvement has been shared across most firms in the sector. The alternative hypothesis operates through workers’ outside options. When a shock is shared across firms where workers’ mobility costs are low (for example, because they share some industry-specific human capital), the worker may have higher bargaining power to negotiate a wage increase since the threat to quit and go to work in another firm becomes more credible.

Our findings suggest that, perhaps not surprisingly, most worker mobility happens within sectors. A worker who changes employer has a 54% higher probability of returning to the same, narrowly defined sector. Perhaps more surprisingly, the data support market forces as the main reason behind a larger response to industry shocks. We show that when the TFP shock is shared across firms within which worker mobility is high, the wage of incumbent workers is more likely to change. Thus, outside options appear to be a crucial determinant of workers’ actual wages even in a country like Sweden where most workers are covered by collective agreements. In other contexts, where wage negotiations are more decentralised (e.g. the US and the UK), this mechanism operating through worker outside options may be even more important.